Leverage (Finance)

Leverage means financing part of a purchase so you can own a bigger asset than your own cash would cover. Cash on cash return exists because leverage makes the return on your equity differ from the return on the property. Without a loan, cash on cash return and cap rate are nearly the same number.

It helps you when cap rate beats the mortgage constant. In that case the borrowed money earns more than its annual cost, and the surplus raises the return on your own cash. It is negative when the debt costs more than the asset earns, and each borrowed dollar subtracts.

At 7.25% over 30 years the mortgage constant is about 8.2%. The default deal's 8.0% cap rate sits just below it, so leverage is slightly negative: 25% down returns 6.3% against 7.7% all cash, and 20% down returns 6.0%. At a 5% rate the constant is 6.4% and the same property has positive leverage. Leverage also magnifies appreciation and loss, which cash on cash does not measure.